FBI pulls off 'perfect hedge' to nab new insider trading class

Posted: December 23, 2011 - 8:09pm

Bloomberg News

NEW YORK — The New York field office of the FBI sits a block west of Foley Square, where Roman and Greek- inspired courthouses with four-story colonnades loom over a small town of judicial institutions in which the biggest of America’s financial crimes are prosecuted.

Almost five years ago, in a conference room 23 stories above the plaza, FBI agents David Chaves and Patrick Carroll surveyed the midtown skyline to the north, home to much of the world’s financial industry. They had received some disturbing intelligence: a surge in profits at hedge funds might be the result of an epidemic of insider trading.

The two men, head of securities and commodities fraud units at the New York office, faced a dilemma. Informants had told them the hedge fund industry was similar to organized crime: insular and distrusting of outsiders. Without people on the inside, the government would have a tough time gathering enough evidence to prosecute. They needed more tools to gather more information on traders who move faster, and more secretly, than your typical Mafia soldier.

“It was reminiscent of that scene in ‘Jaws’ where they get their first look at the shark,” Chaves said. He told Carroll, “We’re going to need a bigger boat.”

That bigger boat came in the form of a landmark change in the way white-collar crime is investigated in the U.S., agents said. The only way to uncover insider trading was to apply the same techniques agents used to dismantle the Mafia: court- authorized wiretaps of phones, informants and cooperating witnesses.

At that moment, “Perfect Hedge” was born. This is the behind-the-scenes story of that historic, sprawling, nationwide insider-trading initiative by those who ran it.

Over the next five years, the operation by the New York offices of the Federal Bureau of Investigation and Manhattan U.S. Attorney led to prosecutions that disrupted multiple rings of illegal trading by portfolio managers, bankers and consultants. It is the biggest insider trading investigation since the days of Ivan Boesky and Michael Milken, and the largest ever in the world of hedge funds.

Agents in New York spent years monitoring clandestine wiretaps as traders received and passed illicit tips. The FBI learned everything it could about fund managers suspected of being criminals, conducting surveillance as targets passed secrets on street corners, in gyms, or handed out bags of money for information.

And it all began with the realization that hedge fund managers who illicitly profited on knowledge the public didn’t have access to could be pursued as vigorously as those who commit more traditional crimes.

“We coined this investigation ‘Perfect Hedge’ because if you’re armed with that insider’s information, you can initiate the perfect hedge,” Chaves said in an interview. “You’re always protected — the upside and the down side.”

The results can be seen in the scores of insider-trading prosecutions made in New York — from the conviction of Galleon Group co-founder Raj Rajaratnam to those involving expert- networking consultants and employees at technology and pharmaceutical companies.

To date, at least 56 people have been charged with insider trading and more than 50 have either pleaded guilty or been convicted after trial as part of the probe, according to the office of Manhattan U.S. Attorney Preet Bharara.

Wiretaps played a role in many of these cases.

“We put people in well-placed hedge funds who reported to us on a daily basis,” said Chaves, 48, a lawyer as well as supervisory special agent.

Ironically, the wiretaps that were so crucial to bringing down defendants in Perfect Hedge will be the basis of an appeal in its biggest case so far, that of Rajaratnam.

In May, the hedge fund manager was found guilty on all 14 counts of securities fraud and conspiracy he faced. The trial showcased 45 recordings by agents working for Chaves and Carroll of the more than 2,400 taped conversations between Rajaratnam and friends, business associates and alleged accomplices.

Prosecutors said he made more than $72 million by using illegal tips. The investigation has also led to charges against former Goldman Sachs board member Rajat Gupta, who pleaded not guilty and faces trial next year.

Rajaratnam, who recently began an 11-year prison sentence, has argued federal laws don’t authorize the use of wiretaps for such an offense. His lawyers plan an appeal, claiming the government didn’t show, as required by law, that conventional techniques couldn’t have been used to achieve similar results.

Two federal judges who ruled the intercepts admissible at trial criticized the government’s tactics.

U.S. District Judge Richard Holwell in Manhattan, who presided over Rajaratnam’s case, allowed the wiretaps to be used as evidence, yet assailed the affidavit the FBI drafted to obtain them for “glaring omissions.”

The U.S. failed to disclose the existence of thousands of documents that had been gathered by investigators and regulators, as well as the true criminal history of a key informant, the judge said.

Daniel Richman, a former federal prosecutor and a professor at Columbia Law School, said the Obama administration has been under pressure by Congress and the media to go after high-stakes white-collar crimes..

Nevertheless, FBI agents and prosecutors must show that other investigative techniques aren’t likely to be adequate to prove a crime is being committed, Richman said.

The FBI’s New York office began by using cooperating witnesses to build insider trading cases. In some instances, Chaves said, agents sent in cooperators wearing wires to record incriminating statements by targets.

Such evidence, he said, “could then be used to provide us enough probable cause to obtain a wiretap.”

Before wiretaps were used, agents had faced a daunting task: penetrating networks of illegal activity in a largely unregulated industry where the pipeline of tips flowed from the U.S. to Europe and even Taiwan. Evidence from recent cases showed that hedge fund managers sent inside information using encrypted e-mails, spoke on pre-paid mobile telephones and used portable flash drives.

To create a pretext for their insider-trading, fund managers often conducted “cover” trades and cited analyst reports as a motive for buying or selling.

Use of wiretaps had an additional benefit: it allowed the targets of an investigation to unwittingly explain complex, multimillion-dollar transactions, making schemes easier for jurors to understand and refuting defendant claims that trades were based on a composite, or “mosaic” of publicly-available information.

Soon after starting Perfect Hedge, the FBI determined that insider trading was a business model at some hedge funds, Chaves said. The industry manages $1.97 trillion in assets, according to Hedge Fund Research Inc. in Chicago.

The landscape of securities fraud crimes was changing, informants were telling the FBI in 2007. So-called boiler-rooms, where corrupt brokers bilked investors by manipulating stocks, were giving way to insider-trading.

At first, the FBI considered sending an agent to work undercover at one of the suspected hedge funds, Chaves said.

“We couldn’t get in. It was such a closed industry — much like an organized crime family — that it was difficult for the FBI to either introduce an undercover agent or recruit a cooperator.”

Danielle Chiesi, a former analyst with New Castle Funds who pleaded guilty in the Galleon case, obtained illegal tips from former International Business Machines Corp. vice president Robert Moffat, who later said he had an “intimate” relationship with her.

Rajaratnam relied on Anil Kumar, a former McKinsey partner, and Rajiv Goel, a former managing director at Intel, whom he’d known for decades. All three attended the Wharton School at the University of Pennsylvania in Philadelphia.

Noah Freeman, a former SAC Capital Advisors portfolio manager who pleaded guilty in Perfect Hedge and agreed to cooperate, said he committed insider trading with two close friends.

The first was Donald Longueuil, the best man at his wedding and also a former fund manager at SAC, a Stamford, Conn.- based hedge fund founded by Steven A. Cohen. The second was Samir Barai, founder of Barai Capital Management. All three have pleaded guilty and are cooperating with the federal probe.

Arthur Cutillo, a former lawyer with Ropes & Gray, used prepaid mobile phones to pass tips about pending mergers he learned of while working at the firm. He gave them to his former college roommate, Jason Goldfarb. In turn, Goldfarb, an attorney in New York, said he gave the inside information to his boss, Zvi Goffer of Galleon. Goffer, 35, provided at least one of these tips to Rajaratnam, according to trial testimony.

With such a tightly knit circle of friends, schoolmates and even lovers, the FBI didn’t have a candidate that could work their way inside, Chaves said.

With Perfect Hedge, the FBI identified lower-level associates and learned enough about them, their crimes and personalities to persuade them to become cooperators.

“For the best FBI agents, it’s the prep work that goes into making sure their approach of a cooperator works, to understand every facet of this person’s life, everywhere they go,” Chaves said. “Because there’s the element of surprise, and the agent is there waiting for you outside your dry cleaner and says, ‘Hey, listen, we need to talk to you.’ The image that portrays to a would-be cooperator is ‘These guys have done their homework and they’ve got me.’ “

Case agents working for Carroll and Chaves are advised to learn everything they can about suspects and individuals they intend to talk into cooperating, Chaves said — everything from whether they favor “Dunkin’ Donuts or Starbucks and where they eat lunch.”

Freeman said FBI agents “flipped” him when he found them waiting by his car in the parking lot of the New England prep school where he worked, after he had left SAC Capital. They played him a recording of his own voice as he was committing insider trading. After that, he gave agents information on at least a dozen people with whom he allegedly committed crimes.

Jason Pflaum, a former Barai Capital analyst, said he decided to secretly cooperate after agents approached him in October 2010. He continued to work for the firm until he pleaded guilty in January. He also said he wore a wire during the same period and gave information to authorities about crimes committed by “more than 10” people.

The FBI also convinced the same friends Rajaratnam corrupted for illegal tips — Kumar and Goel — to testify against the hedge fund manager at trial, along with former Galleon portfolio manager Adam Smith.

Perfect Hedge began to expand even further with cooperators such as Karl Motey, an independent consultant who posed as a hedge fund manager and wore a wire as part of the investigation. He represented a new stage of the probe, as it leapfrogged from hedge funds trading in technology stocks to the company employees who provided the tips — all via so-called expert networking firms.

Expert networkers, or matchmaking firms as Chaves called them, place industry experts with fund managers looking for an inside perspective on a company and industry. Some also passed nonpublic information to fund managers for money, the U.S. said.

Motey secretly recorded conversations with James Fleishman and Bob Nguyen, both executives with expert networking firm Primary Global Research. He also recorded phone consultations with technology firm employees moonlighting for Mountain View, Calif.-based Primary Global as they passed illegal tips to their hedge funds clients, according to evidence revealed in court.

Fleishman was convicted in September following a trial. Nguyen, who cooperated with the U.S. and testified against him, pleaded guilty.

Agents working on separate investigations began running into each other, Chaves said, eventually revealing that what were initially thought to be unrelated schemes were in fact a web of insider trading conspiracies that crisscrossed industries, countries and people.

“Everyone who started cooperating seemed to know everyone else,” the agent said. “As big as this industry is, it’s also that small, at least the core of people who were engaged in this conduct.”